The unexpected withdrawal of large currency notes earlier this month is the latest and boldest move of the government to date to tackle the corruption and tax evasion that have long hurt state revenues.

However, the move has been poorly implemented and is at best a one-time crackdown on illegal cash.

Longer-term solutions to corruption will require the government to complement the latest measure with additional policy changes that address some root problems such as political financing.

Prime Minister Narendra Modi’s announcement on 8 November to immediately withdraw all 500- and 1,000 rupee notes – worth about USD 7.50 and USD 15, respectively – from circulation has been the Indian government’s boldest move yet to crackdown on so-called black money and unaccounted wealth in the country. Combined, the two bills have accounted for nearly 86 percent of the currency in circulation by value.

The primary goals of the drastic move of rendering the two notes illegal are to bring back untaxed wealth into the economy and curb illicit practices such as counterfeiting of notes. The government is also issuing new 500-rupee notes and introducing a 2,000-rupee denomination as part of its policy. Citizens have until the end of 2016 to exchange or deposit their old notes before they are deemed worthless.

The policy has caught many by surprise in a country where – by the government’s own estimate – about 1 percent of the population pay taxes and 80 percent are employed by the informal economy, which accounts for roughly a quarter of the GDP. The sudden nature of the announcement also ensured that those with illicit cash reserves had little time to prepare for alternative means to hide their wealth.

Positive trend

Demonetisation represents a step forward in India’s fight against corruption, which along with complicated tax rules, has long been among the key concerns for foreign businesses in India. India was ranked 76 among 168 countries in Transparency International’s 2015 Corruption Perception Index, and the World Economic Forum’s Global Competitive Index for 2016-17 listed tax regulations and corruption as the top two problematic factors for doing business in India.

The past few months have seen New Delhi take a series of measures against corruption and tax evasion. The government ran a tax amnesty programme from June to September that allowed citizens to report previously undeclared assets without the risk of prosecution, although it levied a 45 percent charge on the wealth. Finance Minister Arun Jaitley said in October 2016 that the programme had brought forth USD 9.8 bn in undeclared assets.

Another initiative was the introduction of the Benami Transactions (Prohibition) Amendment Act which came into effect on 1 November. The law targets property transactions made under fictitious names and those where the ultimate beneficiaries are not traceable. This, along with the move against illegal cash holdings, is likely to affect the property sector where nearly 70 percent of the funds are thought to be black money, with real estate data firm PropEquity estimating that housing prices in major cities could decline by about 30 percent in the next six to 12 months.

With the latest demonetisation policy, the government is also seeking to tackle another significant problem of counterfeit notes circulating in the economy and the poor mechanisms in place to identify them. According to data from the Indian Statistical Institute, nearly 250 in every 1 mn bank notes are believed to be counterfeit, meaning fake notes with a face value of about USD 58.24 mn are in circulation at any given point. The new 500 and 2,000 rupee notes vary in size and thickness from the notes withdrawn from circulation, which makes them harder counterfeit, according to Reserve Bank of India Governor Urjit Patel.

The withdrawal of large currency notes has also caused chaos among cash-dependent hawala brokers, who act as middlemen in the undocumented flow of money between countries without physically moving the funds. With the system popularly used for big and small overseas transactions for tax evasion, money laundering, and terrorism financing, there have been several reports of brokers temporarily stuck with large reserves of 500- and 1,000-rupee notes, with some even burning money worth thousands of dollars in order to avoid detection by law enforcement agencies. In the short term, these hawala networks are likely to continue facing severe disruptions, as it may be a few months before brokers are able to amass cash reserves again.

Implementation hurdles

In a country where about 75-80 percent of all transactions are thought to be cash-based, the initiative to remove the majority of the currency in use within 50 days has faced major implementation challenges. The sudden nature of the announcement combined with the tight deadline has created cash shortages and prompted long queues at banks and ATMs as people try to deposit old notes and withdraw money amid cash rationing imposed by the government, which is struggling to print new notes at a pace sufficient to match demand.

Moreover, the new notes are not compatible with most existing ATMs, necessitating the recalibration of the country’s 220,000 cash machines. As a result, the burden on small businesses and ordinary citizens, mainly in rural areas, has been disproportionately onerous. People have been forced to camp outside banks and ATMs in order to be able to withdraw money before banks run out of cash. There have even been reports of the elderly dying of exhaustion in queues and people committing suicide out of desperation.

Moreover, while the altered design features of the 500- and 2,000-rupee are not sufficient to improve the security of the notes, and there have been numerous reports of the 2,000 rupee note being counterfeited using photocopy machines and police have made several arrests across the country.

Crucially, the introduction of a higher denomination like 2,000 rupees and the reissuing of new 500-rupee notes suggest that at best, demonetisation will be a one-time assault on illicit wealth held in large-denomination notes. The policy does little to target the wealthy corrupt, who tend to hold their illicit wealth in stocks, offshore accounts, property, or gold rather than cash and have been relatively unaffected by the move. Moreover, while authorities may hope that the sudden, unprecedented move will somewhat deter the hitherto significant reliance on physical money and disincentivise massive accumulation of illicit cash in the future, the inherent risk of government corruption remains unaddressed.

The initiative has also prompted sharp criticism from a range of regional parties as well as the opposition Congress party, which have accused the government of inconveniencing millions of people for political gain ahead of key local elections in important states such as Uttar Pradesh and Gujarat in early 2017. Cash plays a major role in electioneering in India – a situation made possible by weak campaign financing laws – and the latest move has temporarily dented the funds available to opposition parties. It has also led to allegations from opponents that members of Modi’s Bharatiya Janata Party were made aware of the action in advance to help protect their cash reserves ahead of what are widely expected to be closely fought elections.

Outlook

In this context, the demonetisation policy – while unprecedented in scale and size – is unlikely to lead to meaningful long-term benefits in isolation. Although the initiative represents a temporary clampdown on unaccounted wealth, it does not deter future attempts to create black money or address other forms of tax avoidance and corruption.

Initiatives such as India’s signed declaration with Switzerland on 23 November under which the government will receive financial information about its residents and their wealth in Swiss bank accounts starting in 2018 signal the government’s continuing commitment to curb other forms of graft. Additional measures, such as imposing curbs on the personal ownership of gold and the elimination of customs duties on the import of gold which has encouraged cash-based transactions, longer-term measures against hawala rackets, as well as concrete efforts to regulate political financing, will also be necessary to address some of the additional long-standing drivers of corruption in India.

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